The Silver Lining Of Bank Downgrades

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 |  Includes: BAC, BCS, C, CS, DB, GS, JPM, MGU, MS, NMR, RBS, RY, UBS
by: Spencer Knight

As the Moody's credit downgrade report becomes imminent it is important to discuss one positive that will come from a slew of downgrades. This silver lining comes from the fact that any downgrade will cause banks to raise their reserve levels. And raising reserve levels will help tame inflation. It will take plenty more tightening to considerably slow down inflation, but if enough banks are forced to hoard cash as collateral then it will play a small part in slowing down the inflation rate.

More specifically, Moody's is in the process of reviewing the long term and/or short term credit ratings of Bank of America (NYSE:BAC), Citigroup (NYSE:C), Goldman Sachs (NYSE:GS), JP Morgan Chase (NYSE:JPM), Morgan Stanley (NYSE:MS), Royal Bank of Canada (NYSE:RY), Barclays (NYSE:BCS), BNP Paribas (BNP.PA), Credit Agricole (ACA.PA), Deutsche Bank (NYSE:DB), HSBC (HSBA.L), Royal Bank of Scotland (NYSE:RBS), and Societe Generale (GLE.PA), while current reviews of Credit Suisse (NYSE:CS), Macquarie (NYSE:MGU), Nomura (NYSE:NMR), and UBS have been extended.

For some of these banks the possibility of a downgrade has weighed heavily on the corresponding stock. Three of the most hit bank stocks over the past few months are Credit Agricole, Societe Generale, and Credit Suisse. Bank of America and Morgan Stanley lead the slide fest for American financial institutions.

Keep in mind there has been a systematic stagnation in equities over the past month, but it is important to note that the 17 stocks being reviewed have greatly underperformed. This indicates that these stocks are under pressure from a possible downgrade. One note to make is that HSBC is an outlier because Moody's is only reviewing the firm's holding branch.

One of the biggest reasons a downgrade will hinder any particular financial institution is because cash must be posted as collateral in case any substantial financial losses occur. This in turn leaves the bank with less money to loan out; which is how banks make the majority of their money. For example, if a financial institution cannot loan, let's say $2 billion to consumers for various projects, then the institution loses revenue from the interest of that loan.

That's not the only problem with a credit downgrade. If, for instance, bank X is downgraded one notch then the bank will need to provide higher yields on bonds. These higher yields are needed in order to reward debt holders for taking on the added risk of default or inability to repay the bond's par value. Thus the financial institution will have to pay debt holders more money in interest rates; which will drag on a bank's cash flows. This will then lead to the stock price adjusting lower to agree with the lower amount of cash flows and income.

As you can see a downgrade from a major ratings agency can cause havoc within a financial institution and the corresponding stock price. Luckily that's the bad news.

The good news is that a slew of downgrades well help to slow the inflation growth rate. Fortunately, according to United States economic data, inflation is not a serious problem right now. However, the TARP funding will eventually rear its head and cause inflation to rise. Also, the longer the Federal interest rates are suppressed the greater the possibility of higher inflation.

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(Source: Inflation.eu)

The majority of the banks up against Moody's are based in Europe. European inflation is slightly above the average over the past 15 years. And after the bailout packages given last year and the possibility of more to come, inflation is a definite threat in Europe. Therefore it may be a blessing in disguise to force several of the major European banks to fill up their reserves. The two euro banks that face a three notch downgrade are UBS and Credit Suisse. As you can imagine, a three notch downgrade will be catastrophic for bond yields and the reserve rates for these two banks.

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(Source: Inflation.eu)

There is one obvious consequence of banks being forced to raise their reserve ratios. This consequence is economic growth. If, for instance, banks are forced to hoard more cash then economic growth will slow. And with global economic growth decreasing or stagnating, this is a serious issue. On the contrary, if national interest rates do not change, then economic growth will likely continue its current path.

As of now it is not known which banks will be downgraded. We can speculate all we want, but nothing is currently known. U.S. banks such as Bank of America, Citigroup, and Morgan Stanley have already stated they are prepared to set aside enough collateral to take care of any downgrade. Bank of America's May 3rd 10-Q states that the firm is ready to commit anywhere from $2.7-$5.1 billion to the reserves dependent upon the severity of the downgrade. Citigroup stated that $1.1 billion in collateral will be needed if Moody's downgrades the firm. Morgan Stanley stated back in February that under a worst case scenario the firm will need to post up to $6.5 billion. Unsurprisingly, these three firm's stocks have been hit hard recently.

Moody's has not given an exact date as to when their reports will be published. They are due before the end of June, but other than that we are in the dark. It is known that the respective stock prices will be volatile up until the report is published and shortly thereafter. Obviously if a downgrade is not given, then the share prices will surge higher. But any downgrade will cause the respective share price to dip; despite these bank stocks giving up substantial portion of their first quarter gains.

We also know that the bond yields for a downgraded bank will increase in order to reward debt holders for a higher risk; or bond prices can be lowered. We will also get a slight positive economic boost as inflation will slow. It may not seem like a few billion dollars can effect inflation, but it can. Therefore even though bank downgrades from major ratings agencies will negatively effect stock prices and make banking operations more difficult in the short to medium term; the tradeoff of slightly lower inflation is well worth the risk.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.